US update: Important things investors should note after a relatively strong first quarter

• US equities (measured by the S&P 500 index) have risen nearly 7% year-to-date as economic growth remains robust, powered by consumption and business investment. 

• Consumer confidence bounced back to the highest level since mid-2021 courtesy of surging stock prices and tight labour market conditions. Lower sensitivity to changes in interest rates have also led to stronger balance sheets.  

• Federal spending programs such as the Inflation Reduction Act (IRA) and the CHIPS and Science Act will spark a new wave of investment within the US and have a positive impact on business investment and job creation. 

• Rising tensions in the Middle East and a robust economy will keep the inflation threat alive. We reiterate our call for no rate cuts this year. 

The momentum in US equities is showing little signs of weakening. As of 24 April 2024, the S&P 500 Index closed at 5,071, roughly 7% above where it started the year. The index also notched an all-time high of 5,264 points earlier in March.  

The strong performance of US equities this year should not come as a huge surprise for investors, given the fact that both top down and bottom-up data seem to suggest that the economy has been doing much better than before.

According to the third and final estimate of GDP growth released by the Bureau of Economic Analysis, real GDP increased at an annual rate of 3.4% in 4Q23, following a 4.9% gain in the previous quarter (Figure 1). Growth in the fourth quarter was mainly driven by increases in consumer spending during the holiday season. For the full year 2023, GDP rose 2.5% versus a gain of 1.9% the year before.  

Looking forward, markets seem to have fully embraced the soft-landing narrative, as economic growth estimates for 2024 were revised up from approximately 1.2% late last year to 2.2% today. Even Fed officials appear to share a similar sentiment, given that they also raised their forecast for GDP growth from 1.4% to 2.1% in the latest summary of economic projections published after the March meeting.

Figure 1: The latest GDP numbers suggest that the economy is doing better than expected

Related Article: Key takeaways from the Federal Reserve and Bank of Japan’s March policy meetings

Robust consumer spending keeps the US economy moving

Like most major economies, consumer spending is the largest component of US economic growth, accounting for approximately two thirds of total GDP. As such, the health of consumers and their attitude towards the state of the economy play a critical role in shaping its trajectory.  

The good news here is that in March, consumer confidence (measured by the University of Michigan Consumer Sentiment Index) reached its highest level since mid-2021, as surging stock prices and better than expected economic data added to investor optimism. 

For instance, recently released labour market data showed that the US added more than 300 thousand jobs in March, way above the consensus forecast of 212 thousand jobs (Figure 2). The unemployment rate also edged lower to 3.8% in March from 3.9% a month earlier. America’s tight labour market is likely to keep wage growth robust which should support further spending. 

Figure 2: Consumer confidence hits the highest level since June 2021

Turning our attention to consumer balance sheets, despite a drop in the savings rate, US households still have 32% more in their bank accounts than they did before the pandemic, providing them with a comfortable buffer to continue spending. 

Although the aggregate household debt balance has risen since the pandemic, American consumers are not overly burdened by it. As of end 2023, not only does the ratio of household debt payments to disposable income remain below pre-pandemic levels, it is also significantly below the level they were at during the height of the global financial crisis (GFC). By most measures, consumer balance sheets are still far from crisis levels. 

Figure 3: Despite a recent rise consumer debt levels are still manageable 

While this may seem like a strange phenomenon given that borrowing costs have increased substantially, there is a good explanation behind it. 

In the aftermath of the GFC, the US implemented significant reforms to the housing market, which include tighter lending standards and enhanced disclosure requirements for non-traditional mortgages such as those with adjustable rates. 

Coupled with the near zero interest rates at the time, many prospective homeowners took out fixed rate mortgages (some of which were locked in for as low as 3%), thereby insulating them from the rise in interest rates. It is estimated that adjustable-rate mortgages make up approximately 10% of all new mortgage originations today vs nearly 40% prior to the GFC. All things considered, US consumers have become less sensitive to changes in interest rates than they were in the past. 

Federal spending programs to spark a new wave of business investment 

Besides the resilient consumption spending, we expect business investment (historically the second largest contributor to GDP growth) to pick up as well. This comes as the US is making a huge push to reshore supply chains in the aftermath of the pandemic and amid rising geopolitical tensions with China. 

Federal spending programs such as the Inflation Reduction Act (IRA) and the CHIPS and Science Act will spark a new wave of investment within the US. Together, these policies promise to deliver over USD 400 billion worth of tax credits/subsidies over the next 10 years, which should serve as a catalyst to incentivise both foreign and domestic investment.

According to data compiled by the Financial Times, the IRA and CHIPS act have stimulated over USD 220 billion worth of investments within one year since the acts were signed. They have also helped to create more than 100,000 jobs since. Notable examples include the likes of Toyota, which has poured in upwards of USD 10 billion across various stages to expand its battery and electric vehicle production capabilities in the US. 

Homegrown chipmaker Intel recently announced that it has secured nearly USD 20 billion of funding from the US government in the form of loans and grants as it gears up to spend USD 100 billion over the next five years to improve its chipmaking capabilities. Intel’s investments are expected to create more than 10,000 new jobs and support more than 50,000 indirect jobs (e.g. suppliers).  

In essence, America’s policies to reshore its supply chain not only results in higher business investment, but it also supports the economy through other channels such as job creation, which should in turn have a positive effect on consumption.

Inflation has started to re-emerge. We reiterate our view of no rate cuts this year

With the economy doing much better than before, it’s no surprise that inflation has started to re-emerge. US consumer prices rose at a faster-than-expected pace in March, coming in at 3.5% year-on-year vs estimates of 3.4%. As a matter of fact, CPI has come in hotter than expected over the past four months driven predominantly by higher services prices. 

Higher inflation readings have already had an impact on markets, especially in recent times. For starters it has prompted the Fed to reevaluate its rate cut trajectory. Fed Chair Jerome Powell signalled that rate cuts are unlikely at this juncture, even as officials pencilled in three rate cuts for 2024 just a couple of weeks ago. Markets have also repriced their rate cut expectations, from six rate cuts at the beginning of the year to just one today (Figure 4).

Figure 4: Investors are expecting just one rate cut today, vs six at the beginning of the year 

Source: CME Group
Data as of 26 Apr 2024

As a result, the 10-year US treasury yield rose from roughly 3.9% at the beginning of the year to 4.6% today. The recent developments on the inflation front are a clear indication that the battle with inflation is far from won. Rising tensions in the Middle East and a robust economy will keep the inflation threat alive. Considering the above, we reiterate our call for no rate cuts this year. Cutting rates at the time when the economy is doing well risks stoking inflation which is the last thing the Fed wants to do now.

Related Article: As we predicted, interest rate cuts are looking less likely. Here’s why

Potential risks to pay attention to 

Election risk: The outcome of the 2024 US presidential election should have a significant impact on US foreign/fiscal policy, which can alter the trajectory of the US economy. For instance, Donald Trump said that if he were to be re-elected, he plans to impose a 60% and 10% tariff on imports from China and the rest of the world respectively. This could spark another trade war with China which would not only be detrimental to markets, but also put a dent in the Fed’s efforts to curb inflation. 

Fed raising interest rates: Hotter than expected inflation readings have prompted the Fed to reevaluate its monetary policy. Should the Fed suddenly decide to raise interest rates, it could shock markets as most investors are still holding onto the idea that the Fed is going to cut rates this year. 

Earnings disappointment: The current stock market rally is not driven purely by stronger economic data. It is also driven by markets pricing in higher future earnings growth for US companies, as observed from the upward revisions in earnings estimates over the past few weeks. If companies fail to live up to investors’ expectations, it could spark a reversal in share prices. 

How should investors position themselves? 

Overall, we hold an optimistic view about the US economy. However, because of the lofty valuations of US equities and our expectation for higher for longer inflation & interest rates, we recommend investors to take a selective approach, favouring sectors that are supported by structural growth drivers or those that demonstrate strong earnings growth/multiple expansion potential. Case in point are the semiconductor and digital economy sectors. 

We also want to reiterate our preference for quality stocks, such as those with strong balance sheets, resilient earnings and wide competitive moats as they should be able to thrive in a challenging environment. We believe that having exposure to high quality companies is a prudent long-term investment strategy, one that all investors should adopt. 

Table 1: Recommended products for US equities

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report holds a position in the VanEck Semiconductor ETF.